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									In Search of Alpha October 2000

Hedge Funds -
The Basics Revisited
Defining Hedge Funds

"During the French Revolution such speculators were known as agitateurs, and they were beheaded.

Michel Sapin

There are nearly as many definitions of hedge funds as there are hedge funds. We think the following is the best description:

Definition                             Hedge funds are private partnerships wherein the manager or general partner
                                       has a significant personal stake in the fund and is free to operate in a variety of
                                       markets and to utilise investments and strategies with variable long/short
                                       exposures and degrees of leverage. 2
                                       Beyond the basic characteristics embodied in this definition, hedge funds
                                       commonly share a variety of other structural traits. They are typically organised as
                                       limited partnerships or limited liability companies. They are often domiciled off
                                       shore, for tax and regulatory reasons. And, unlike traditional funds, they are not
                                       burdened by regulation.
Alternative Investm ent                AIS comprise an asset class that seeks to generate absolute positive returns by
Strategies (AIS)                       exploiting market inefficiencies while minimising exposure and correlation to
                                       traditional stock and bond investments. Normally, private equity as well as hedge
                                       fund investing are referred to as AIS.
Skill-based strategies                 As we elaborate later in this report, the reputation of hedge funds is not particularly
versus strategies capturing            good. The term 'hedge fund' suffers from a similar fate as 'derivatives' due to a
an asset class                         mixture of myth, misrepresentation, negative press and high-profile casualties.
                                       Hedge fund strategies are occasionally also referred to as skill-based strategies or
                                       absolute return strategies which, from a marketing perspective, avoids the negative
                                       bias attached to the misleading term 'hedge fund'. Skill-based strategies differ from
                                       traditional strategies. The former yields a particular return associated to the skill of
                                       a manager whereas the latter primarily captures the asset class premium. Skill-based
                                       strategies involve, from an investors perspective, the following three attributes:
                                       • High expected risk-adjusted returns;
                                       • Low correlation with traditional asset classes;
                                       • A source of return not explained by the Capital Asset Pricing Model.

Michel Sapin, form er French Finance Minister, on speculative attacks on the Franc (from Bekier 1996)
from Crerend 1995
In Search of Alpha October 2000

Main Characteristics of the Hedge Fund Industry

Industry Size and Grow th

           US$1tr assets under        Estimates of the size of the hedge fund industry are scarce and deviate substantially.
           m anagem ent as of 1998    The estimates for the number of funds ranges between 2,500 and 6,000 and assets
                                      under management between US$200bn and US$1tr. The President's Working
                                      Group estimates that the hedge funds universe as of mid-1998 was between 2,500
                                      and 3,500 funds, managing between US$200bn and US$300bn in capital, with
                                      approximately US$800bn to US$ 1tr in total assets.'

           Still a niche industry     Compared with other US financial institutions, the estimated US$1tr in assets under
                                      management remains relatively small. At the end of 1998, commercial banks had
                                      US$4.1tr in total assets, mutual funds had assets of approximately US$5tr, private
                                      pension funds had US$4.3tr, state and local retirement funds had US$2.3tr, and
                                      insurance companies had assets of US$3.7tr. 2

           The CalPERS bom bshell -   The California Public Employees' Retirement System (CalPERS) dropped a
           legitim ising hedge fund   bombshell on the hedge fund industry on 31 August 1999, when it released a
           investing                  statement saying it would invest as much as US$1 1bn into 'hybrid investments',
                                      including hedge funds. While many other large and sophisticated institutional
                                      investors have been investing in the AIS sectors for years, the announcement by
                                      CalPERS further legitimised AIS investments for the broad base of institutions
                                      seeking viable alternatives to their reliance on ever-increasing stock prices. One
                                      year after the LTCM collapse, when it was nothing more than a fading memory,
                                      new hedge funds were hatching at the quickest pace ever seen. Net capital flows
                                      into the industry were picking up from 1998's retrenchment, placing the industry on
                                      the threshold of a long-term boom.

           Som e of the m ost         While sophisticated individual investors (up to 75% of hedge fund assets, according
           conservative and           to some estimates)3 have historically targeted hedge funds, in recent years the
           sophisticated investors    participation of institutional investors has risen. In the US, for example, institutional
           invest in hedge funds      investors accounted for nearly 30% of new money flowing into hedge funds in the
                                      past few years. University foundations and endowments are among the most
                                      aggressive institutional investors. It is commonly known that the 'Ivy League'
                                      schools such as Harvard and Princeton have large allocations to hedge funds. On
                                      the corporate side, large conservative firms such as IBM or RJR Reynolds have
                                      been investing in hedge funds for years. Pension funds, under pressure to constantly
                                      look for new ways to diversify their holdings, are also starting to allocate capital to
                                      hedge funds. In addition, over-funded pension funds seek to preserve wealth by
                                      lowering risk
                                      I Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management - The Report of The President's
                                       Working Group on Financial Markets, April 1999.
                                      2 From Board of Gov ernors of the Federal Reserv e Sy stem, Flow of Funds Accounts of the United Sta tes,
                                      Fourth Quarter
                                      3 See Hopkins (2000)
In Search of Alpha October 2000

Supply driven expansion in         Increased institutional participation portends a fundamental shift in the quality of
the past versus….                 hedge fund programmes. In the past, the establishment of hedge funds has been
                                   largely supply-driven. Successful investors, often the heads of proprietary trading
                                  desks, decided to forego their lucrative seven and eight figure Wall Street
                                  remuneration packages to establish boutique organizations as the primary vehicle
                                  for managing their own personal assets. Earning a return on their own assets (versus
                                  the collection of fees from outside investors) was the primary motivator for early
                                  hedge fund entrants. Entry costs were high as the dealer community set lofty
                                  standards for those to which it would lend money/stock and establish trading lines.

…today's demand driven            Increasing participation from institutions is beginning to shift the expansion from
growth                            being supply driven to demand driven. This motivates a vast group of aspirants to
                                  enter the competition for these new US dollars and euros. At the same time, the
                                  barriers to entry have been tom down. There have been hedge funds launched by
                                  20-year olds with little to no resources or investment experience.

Growth in funds-of-funds          As a result, the differentiation between quality and sub-standard managers is
industry                          becoming more pronounced. Quality hedge fund managers should benefit from a
                                  proliferation of ill-managed funds, while investors need to stay alert to this potential
                                  degradation in the quality of hedge fund management. This proliferation and the
                                  high costs associated with actively selecting hedge funds are among the main
                                  reasons for accelerated growth in the funds -of-funds-industry. We will take a closer
                                  look at funds-of-funds on p94.

                                  The following two sections examine the distribution of dollars invested in hedge
                                  funds, by fund size and by fund investment style.

Source: Van Hedge Fund Advisors
In Search of Alpha October 2000

Average fund size is falling              Chart 1 shows the distribution of hedge funds by size. As of 1999, around 83% of
                                          all funds under management were allocated to funds below US$100m and around
                                          52% to funds smaller than US$25m. The average size of hedge funds is decreasing.
                                          Based on the 1,305 hedge funds in the MAR/Hedge database (not shown in graph),
                                          the average fund size in October 1999 was US$93m compared with US$135m a
                                          year earlier.
Distribution by Style
Table 1: Number of Funds and Assets Under Management by Style as of 1998

(%)                                                                                          Funds             Assets under
Long/short equity                                                                              30.6                    29.8
Managed futures                                                                                18.6                    15.9
Funds-of-funds                                                                                 14.1                     NA*
Event-driven                                                                                   11.9                    16.6
Emerging markets                                                                                5.6                      3.5
Fixed income arbitrage                                                                          5.1                      7.7
Global macro                                                                                    4.0                    14.9
Equity market neutral                                                                           3.8                      3.9
Convertible arbitrage                                                                           3.5                      4.4
Equity trading                                                                                  1.1                      2.4
Dedicated short bias                                                                            0.5                      0.4
Other                                                                                           1.2                      0.5

Source: Tremont (1999)

* As funds of funds invest in other funds the percentage of all hedge funds assets under management has not been given to avo id double counting

Equity long/short largest                 Long/short equity is the largest style with a market share of around 30%, based on
investment style                          the number of funds as well as assets under management. The funds of funds
                                          industry was around 12-14% of the total number of funds. We expect this
                                          percentage to increase, as for most investors a diversified exposure to hedge funds
                                          is more appropriate than carrying single-fund risk and picking single hedge funds is
                                          time consuming and costly. We will address the costs of picking hedge funds later
                                          in the document (p94)

Fewer macro funds                         Note that only around 4% of funds are macro funds but they represent around 15%
                                          of the industry. The percentage of macro funds fell to around 22% by 1997 (Table
                                          2) and 15% by 1998 (Table 1). We expect these percentages to be even lower today
                                          after large losses (Tiger) and retreats (Quantum). The following table compares
                                          allocation differences between 1990 and 1997.
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Table 2: Assets Under Management Comparison Between 1990 and 1997

(%)                                                                            1990             1997             Change
Macro                                                                          50.6              22.4              -28.2
Equity Non-Hedge                                                               14.1              15.8                1.7
Equity Hedge                                                                    9.8              14.8                5.0
Em erging m arkets                                                              2.8              12.7                9.9
Event-Driven                                                                    4.5               7.9                3.4
Equity m arket-neutral                                                          1.0               4.7                3.7
Sector                                                                          0.5               3.5                3.0
Distressed securities                                                           1.7               2.5                0.8
Fixed incom e arbitrage                                                         0.6               2.0                1.4
Convertible arbitrage                                                           1.9               1.8               -0.1
Risk arbitrage                                                                  0.2               0.9                0.7
Short selling                                                                   2.7               0.2               -2.5
Other                                                                           9.6              10.8                1.2

Source: Nicholas (1999)

Note that Equity Non-Hedge and Equity Hedge is roughly what others define as long/short equity. The market share of long/short
equity, therefore, is around 30%. This is consistent with data from Tremont (1999).

Use of Leverage

Different hedge fund                    Leverage is an important issue to most investors when investing in hedge funds.
strategies require different            Institutionally, leverage is defined in balance sheet terms as the ratio of total assets
degrees of leverage                     to equity capital (net worth). Alternatively, leverage can be defined in terms of risk,
                                        in which case it is a measure of economic risk relative to capital.

Vulnerable to liquidity                 Hedge funds vary greatly in their use of leverage. Nevertheless, compared with
shocks                                  other trading institutions, hedge funds' use of leverage, combined with any
                                        structured or illiquid positions whose full value cannot be realised in a quick sale,
                                        can potentially make them somewhat fragile institutions that are vulnerable to
                                        liquidity shocks. While trading desks of investment banks may take positions
                                        similar to hedge funds, these organisations and their parent firms often have both
                                        liquidity sources and independent streams of income from other activities that can
                                        offset the riskiness of their positions.

                                        The following table shows our own estimates of how different hedge fund managers
                                        are typically leveraged.
In Search of Alpha October 2000

Table 3: Estim ated Use of Balance Shee t Leverage

                          (%)      Balance-sheet leverage
                          Fixed incom e arbitrage    20-30
                          Convertible arbitrage      2-10
                          Risk arbitrage    2-5
                          Equity m arket-neutral     1-5
                          Equity Long/Short          1-2
                          Distressed securities      1-2
                          Em erging m arkets         1-1.5
                          Short selling     1-1.5
                          Source: UBS Warburg estimates

Around 72% of hedge funds         Based on a report from Van Money Manager Research around 72% of hedge funds
use leverage    used leverage as of December 1999. However, only around 20% have balance-sheet
                          leverage ratios of more than 2:1. Fixed income arbitrageurs operate with the
                          smallest margins and therefore gear up heavily to meet their return target. Hedge
                          funds that operate in emerging markets, for example, use little leverage primarily
                          because derivatives markets and securities lending is not developed.

                                   Using leverage and using derivatives are often regarded as synonymous. This is a
                          misconception, which we address later in the document (p88). Table 4 shows the
                          use of derivatives by investment style.

Table 4: Use of Derivatives of Global Hedge Funds in 1995

          (%)                          No derivatives                 Use of derivatives
                                                 Total        Hedging     Yield enhancem ent    Both            Total
                                                                  only             only
          Total Sam ple                           28.1            48.8               1.4         21.7            71.9

          Fund of Funds                               6.3           53.4               0.0              40.2          93.7
          Market Tim ing                             13.8           55.2               6.9              24.1          86.2
          Macro                                      20.5           38.6               0.0              40.9          79.5
          Em erging Markets                          21.6           64.9               0.0              13.5          78.4
          Short Selling                              23.3           46.7               0.0              30.0          76.7
          Market Neutral - Arbitrage                 23.5           55.1               1.0              21.4          76.5
          Opportunistic                              23.9           36.6               5.6              33.8          76.1
          Special Situations                         25.0           63.2               0.0              11.8          75.0
          Market Neutral - Securities Hedging        33.3           43.3               0.0              23.3          66.7
          Incom e                                    35.1           43.2               0.0              21.6          64.9
          Value                                      37.6           50.5               2.6               9.3          62.4
          Distressed Securities                      42.9           37.1               0.0              20.0          57.1
          Several Strategies                         46.3           41.5               0.0              12.2          53.7
          Aggressive Grow th                         47.4           40.9               0.6              11.1          52.6

Source: Van Money Manager Research
In Search of Alpha October 2000

Incentive to hedge                Around 72% of hedge funds use derivatives primarily for hedging purposes. Unlike
                                  other money managers, the hedge fund manager's use of derivatives is not constrained by
                                  regulatory barriers. Furthermore, many hedge fund managers co me from a risk management (as
                                  opposed to a fund management) background which implies knowledge of risk management
                                  instruments and experience in its markets. A further reason for the extensive use of derivatives
                                  is the fact that the hedge fund managers' own capital is at stake. Capital depreciation of the
                                  fund, therefore, has a greater impact on the managers' wealth. Hence, a hedge fund manager has
                                  a large incentive to hedge (ie, preserve wealth).

                                  Some long-established macro funds find the fees on complex derivatives prohibitive. They find
                                  it cheaper to use conventional forwards and futures to take positions ahead of the market
                                  moves they foresee. Some newer macro funds pursue more specialised trading strategies using
                                  complex derivative securities. Relative-value funds are also inclined to use derivatives because
                                  the mis-priced securities they are seeking can be hidden within complex derivatives that
                                  combine several underlying assets.

High leverage is the              Hedge funds leverage the capital they invest by buying securities on margin and
exception rather than the         engaging in collateralised borrowing. Better known funds can buy structured
rule                              derivative products without first putting up capital, but must make a succession of
                                  premium payments when the market in those securities trades up or down. In
                                  addition, some hedge funds negotiate secured credit lines with their banks, and
                                  some relative value funds may even obtain unsecured credit lines. Credit lines are
                                  expensive, however, and most managers use them mainly to finance calls for
                                  additional margin when the market moves against them. These practices may allow
                                  a few hedge funds to achieve very high leverage ratios.

                                  Characteristics of the 'Average' Hedge Fund

The hedge fund industry is        There is no typical hedge fund. One of the industry's main characteristics is
heterogeneous                     heterogeneity and not homogeneity. However, Table 5 lists some averages from the
                                  Van Hedge hedge fund universe. Table 6 on p 13 lists some further characteristics.
In Search of Alpha October 2000

Table 5: Global Hedge Fund Descriptive Statistics, as of Q4 99

                                                                                              Mean        Median                 Mode
Fund size (US$m )                                                                                 87            22                    10
Fund age (years)                                                                                 5,9           5.3                   5.0
Minim um investm ent (US$)                                                                  695,000       250,000               250,000
Num ber of entry dates                                                                            34            12                    12
Num ber of exit dates                                                                             28             4                     4
Lockup period*                                                                              84 days         0 day                    NA
Advance notice*                                                                             35 days       30 days                    NA
Managem ent fee (%)                                                                              1.7           1.0                   1.0
Perform ance related fee (%)                                                                    15.9          20.0                 20.0

Manager's experience (years)
    in securities industry                                                                        17            15                    10
    in portfolio m anagem ent                                                                     11            10                    10

Source: Van Money Manager Research; Liang (1999).
* From Liang (1999) and as of July 1997

The mean measures the arithmetical average. The median measures the point on either side of w hich lies 50% of the distributio n. A median is often
preferred over the mean as a measure of central tendency because the arithmetic average can be misleading if extreme values are present. The
mode is the number, w hich occurs most frequently

Table 6: Trends in Descriptive Statistics betw een 1995 and 1999

Characteristics                                                                                                      Yes 1995 Yes 1999
                                                                                                                          (%)  (%)
Manager is a US registered investm ent advisor                                                                             54   45
Fund has hurdle rate 1                                                                                                     17   17
Fund has high w ater m ark 2                                                                                               64   75
Fund has audited financial statem ents or audited perform ance                                                             97    98
Manager has US$500,000 of ow n m oney in fund                                                                              78    75
Fund can handle 'hot issues' 3                                                                                             25    53
Fund is diversified                                                                                                        57    57
Fund can short sell                                                                                                        76    84
Fund can use leverage                                                                                                      72    72
Fund uses derivatives for hedging only, or none                                                                            77    71

Source: Van Money Manager Research

We will highlight some of the characteristics in Table 6 when we compare hedge funds with mutual funds on p51. In the following
section we discuss the

1 Hurdle rate: The return above w hich a hedge fund manager begins taking incentive fees. For example, if a fund has a
hurdle rate of 10%, and the fund returns 25% for the year, the fund w ill only take incentive fees on the 15% return above
the hurdle rate.
2 High w ater mark: The assurance that a fund only takes fees on profits unique to an individual investment. For example, a
US$1,000,000 investment is made in year one and the fund declines by 50%, leaving US$500,000 in the fund. In year
tw o, the fund returns 100%, bringing the investment value back to US$1,000,000. If a fund has a high w ater mark, it w ill
not take incentive fees on the return in year tw o, since the investment has never grow n. The fund w ill only take incentive
fees if the investment grow s above the initial level of US$1,000,000.
3 A new ly issued stock that is in great demand and rises quickly in price. Special rules apply to the distribution of hot
                              developments in Europe which many regard as a growth area for raising capitol for absolute
                              returns strategies.

                              The Situation in Europe
56% of institutions either    Ludgate1 conducted a survey on the hedge fund industry in Europe from an
currently invest (17%) or     investor’s perspective. The sample size was 100 major European institutional
plan to invest (39%)          investors domiciled in UK, Germany, France, Switzerland, Italy, Netherlands, and
institutional m oney in       Scandinavia. The number of sample institutions for each market was based on
hedge funds in the future     relative weighting of total assets under management in each market. All respondents
                              were senior personnel involved in investment management, including 39 CIOs.
                              Total assets of sample institutions represented over 60% of total assets under
                              management by European institutions. The major findings summarized as:

                              -    56% of institutions surveyed either currently invest (17%) or plan to invest
                                   (39%) institutional money into hedge funds in the foreseeable future;

                              -    Current investment money in hedge funds was greatest in France (33%
                                   of investors) and Switzerland (30%) and lowest in Germany (7%) and Italy (0%);

                              -    Biggest hedge fund growth markets were Scandinavia (67% of current non -
                                   Investors) and the Netherlands (62%);

                              -    65% of all institutions surveyed thought that hedge funds would become an
                                   asset class in themselves

Sw itzerland w ill have the   Adding current institutional money in hedge funds to the funds which plan to enter
largest and Germ any the      the industry would result in Switzerland (87%) having the largest allocation of
sm allest institutional       institutional money, followed by the Netherlands (82%) and Scandinavia (77%).
allocation to hedge funds
                              1The Future Role of Hedge Funds in European Institutional Asset Management , by Ludgate Communications, March
In Search of Alpha October 2000

                                  The smallest allocation would be held by German (24%) and Italian investors

"We are not a casino!" - an       Based on this survey, investing in hedge funds is not something widely considered
investor                          by German investors. One investor was quoted as saying:

                                      "No, we don't (currently invest in hedge funds)! It is completely obvious
                                      that hedge funds don't work. We are not a casino.

                                  Note that the survey was conducted at the CIO level. Another investor was quoted
                                  arguing that investing in hedge funds is against their philosophy and that hedge
                                  funds still have a stigma attached to them.

                                  An Indocam/Watson Wyatt survey 1, which reveals similar results as the Ludgate
                                  survey, took a sample consisting of continental European pension funds across nine
                                  markets, Belgium, Denmark, France, Germany, Ireland, the Netherlands, Portugal,
                                  Sweden and Switzerland. The survey contacted senior decision -makers at 284
                                  continental European pension funds. Respondents were interviewed by telephone
                                  by experienced foreign language market researchers for an average time of about 25

                                  The Indocam/Watson Wyatt survey addressed AIS in general, whereas the Ludgate
                                  survey focused particularly on investing in hedge funds.
In Search of Alpha October 2000

European pension funds            Of the Є886m in alternative investments analysed, private equity, hedge funds and
have a sm all allocation to       CTAs and international venture capital were found to be the most popular.
AIS                               Nevertheless, within the context of the total investments made by all respondents,
                                  which totalled Є452bn, the alternative investment exposure is extremely small.

Sw iss pension funds have         Although 36 respondents invest in alternative asset classes, the predominant
the largest allocation to AIS     appetite accounting for over 90% of all mandates by value analysed was for Swiss
                                  respondents. Switzerland is believed to be one of the most important customer bases
                                  for non-traditional funds (Cottier 1996). Traditionally, many private banks in
                                  Geneva and Zurich have become spons ors and distributors of hedge funds through
                                  their vast private client base. Following a change in Swiss pension fund regulations,
                                  Swiss pension funds are allowed to take on more risk as long as they adhere to the
                                  'Prudent Man Rule' 1

The European pension fund         The generally low allocation to hedge funds by non-Swiss pension funds in Europe
puzzle                            is puzzling. Relative performance and benchmarks may enable traditional managers
                                  to look at their competitive position relative to their peer group. But, consistent
                                  long-term returns - independent of market movements - make a compelling reason
                                  for embracing the world of absolute return for all investors, including pension
                                  funds. Concepts such as the core-satellite and/or the portable alpha approach 2 to
                                  investing large amounts of money strongly favour hedge fund investing for the
                                  active mandate in these approaches.

                                  A further interesting aspect of the Indocam/Watson Wyatt survey is the selection
                                  criteria for alternative investment managers. Table 9 shows the most important
                                  alternative investment manager selection criteria analysed geographically for those
                                  pension funds that are currently outsourcing these types of mandate. Table 9 only
                                  shows respondents from three countries for presentation purposes.

                                  IIn the US, f or more than a century , the inv e6tment actions of f iduciaries hav e been subject to the test of the 'Prudent
                                  Man Rule' as interpreted by US courts. As enacted into legislation by most US states, the Prudent Man Rule holds that a
                                  f iduciary shall exercise the judgement and care, under the circumstances then prev ailing, which men of prudence,
                                  character and intelligence exercise in the management of their own af f airs, not in regard to speculation but in regard to
                                  the permanent disposition of their f unds, considering the probable income as well as the probable saf ety of their capital.
                                  2 The core-satellite approach is an alternativ e to the 'all inclusiv e' balanced asset allocation approach. In a core-satellite

                                  strategy , a money manager will inv est ty pically 70-80% of its assets in an index tracking f und. Specialist f und managers
                                  are hired around this 'passiv e core' as 'satellites' to inv est in sectors where index -tracking techniques are dif f icult to
                                  apply , f or example AIS, smaller companies or emerging markets.
                                  With the portable alpha approach, the alpha of a manager or group of managers or strategy is transported to a target
                                  index. For example a pension f und allocates its f und to a bond manager who generates an alpha of 200bp y early without
                                  an increase in credit risk. In addition it swaps total returns of an equity index with the risk f ree rate. The end result is the
                                  total index return plus 200bp. This approach can be used quite broadly . Alpha can be generated in many dif f erent areas
                                  and transported into v irtually any index. The limiting f actor is the av ailability of deriv ativ es to carry out the alpha
                                  transf er. One of the disadv antages is the cost of the transf er. Howev er, if the target index is an index with a liquid
                                  f utures contract, the costs are usually less than 1 00bp per y ear.
In Search of Alpha October2000

Mandate suitability is m ost     Generally, the selection criteria do not differ substantially from those exhibited for
im portant                       more conventional asset mandates. There is a considerable amount of u niformity
                                 relating to what respondents regarded as the most important of alternative
                                 investment manager selection criteria. These criteria generally relate to the mandate
                                 suitability, calibre of investment professionals and continuity, investment
                                 performance and client servicing.

Fees do not seem to be an        Once again, the least important of the alternative investment manager selection
issue in selecting a             criteria were remarkably similar when analysed geographically. Respondents
m anager                         generally believed the 'softer' factors to be less important than selection criteria,
                                 namely brand comfort, culture of organisation, and prior knowledge of organisation.
                                 Additionally, fees were not deemed to be of particular importance for selection.
                                 Generally, the more operational of selection criteria, particularly quality of
                                 reporting and administration, were regarded as being of moderate importance by

Low correlation is m ost         When asked for their rationale for investing in AIS, the respondents collect ively
attractive feature               chose average low correlation as the most important aspect followed by
                                 outperformance against equity, outperformance against fixed income and hedge
                                 against inflation.

                                 According to Watson Wyatt and Indocam, of the 196 contin ental pension funds
                                 surveyed, some 30% outsourced to hedge funds or other alternative investment
                                 managers. Another 8% believe they will be doing so within three years. The
                                 following table shows future market appetite for AIS by 2003, based on the survey
InSearchofAlpha October2OOO
                                 Table 10: Future Market Appetite for AIS to 2003

                                                     No. of funds       % of fund invested in alternative asset classes by 2003
                                 Belgium                        2                                                  2-10
                                 Denmark                        6                                                   1-5
                                 France                         1                                                     1
                                 Germany                        2                                                     1
                                 Ireland                        1                                                     3
                                 Netherlands                   10                                                  2-10
                                 Portugal                       1                                                     5
                                 Sweden                         6                                                   5-9
                                 Switzerland                   14                                                   2-9

                                 Source: IndocamNatson Wyaft

Allocations to AIS are           Indocam/Watson Wyatt anticipate a rise of the allocation to alternative investments
growing in Europe                by respondents who already invest in AIS as well as those who are about to invest
                                 in these asset classes. The allocation from European pension funds could rise from
                                 less than Єlbn to in excess of Є12bn. As many Swiss respondents did not respond to the
                                 outlook for three years, this figure is probably understated.

                                The most considerable growth is expected to come from the Dutch, Swedish and Swiss pension
                                funds. Elsewhere, there is expected to be some appetite, at least, expressed, which is consistent
                                with the findings from the Ludgate survey.

No hedge funds, please,          EuroHedge ran a story, examining why UK investors have a small allocation to
growing in Europe                hedge funds. It seems UK investors are following John Maynard Keynes' maxim that "worldly
                                 wisdom teaches us that it is better for reputation to fail conventionally than to succeed
                                 unconventionally." One of the deterrents is the fact that all investments, except UK equities an d
                                 bonds, are excluded from the government's minimum funding requirement. Another stumbling
                                 block is that, unlike their European counterparts, UK funds do not like pooled investment
                                 vehicles because of poor past experiences. And mid-sized pension funds appoint their
                                 managers as custodians, which hinders the adoption of specialist strategies. Allocating returns
                                 from pooled vehicles to individual clients is an obstacle.

Fee structure is a concern       While fees are of limited concern to pension fund managers on the continent (as
in the UK                        surveys suggest), fees are a big stumbling block in the UK, according to
                                 EuroHedge. To the trustees of the average UK fund, which pays about 30bp for
                                 management, hedge fund charges of 1% or 2% management and 20% performance
                                 appear astronomical. Unless they are convinced that the value added is worth the
                                 charges, trustees are even less likely to pay an extra layer of fees for a fund of

Difficulties measuring total     Another problem is that large UK pension funds aim for a target equity market
exposure to equity market        exposure, and will likely be either under or overweight their guidelines if their
                                 hedge fund manager's beta is constantly changing - as it will, especially if the

                               1 EuroHedge, 31 July 2000.
JnSearchofAlpha October2OOO
                              manager uses leverage. This, in turn, makes it difficult for pension funds to track
                              ‘active risk’ against their benchmark. In addition, the allocation by sector is
                              becoming more important.

British abstinence is         However, the fact that these problems are being discussed is evidence of changing
changing for the better       attitudes. Pension consultants are warming to the concept of hedge funds - though
                              with great caution, so as not to alienate clients.

                              This concludes our brief round up of the hedge fund industry. In the following
                              section, we describe the different hedge fund strategies.
In Search of Alpha October2000

                                 Hedge Fund Strategies

                                 Defining Hedge Fund Styles

The beta of hedge funds          We believe that one of the most important issues from an investor's perspective in
can differ w idely               terms of investing in hedge funds is the knowledge about the different investment
                                 styles in the hedge fund industry. Equity investors are typically familiar with the
                                 fact that the equity market has different sectors and styles to invest in and that the
                                 different styles have different return, risk and correlation characteristics. The same
                                 is true for hedge funds. There is a vast amount of different strategies available. The
                                 style differences of hedge funds differ widely in one respect with styles and sectors
                                 in the equity arena. In equities, all sector and style indices have a beta (exposure) to
                                 the market of around one. The beta of the different hedge fund styles varies from
                                 minus a multiple of one (short seller using leverage) to a multiple of plus one (long
                                 biased fund using leverage).

                                 Chart 4 segments some hedge fund strategies into styles and sub -styles. The
                                 classification is subjective. As with equities, there are different style classification
                                 systems in the market. For this report we focused on exposure (and therefore
                                 correlation) to the general market of the different strategies.

Am biguous classification        One of the main differences between hedge funds and other money managers is, as
                                 mentioned above, their heterogeneity and the fact that hedge funds are less
                                 regulated. This means categorising hedge funds is difficult and the above
                                 classification is therefore subjective, inconsistent with some hedge fund data
                                 vendors and incomplete. Any classification of hedge funds is an attempt at fitting
                                 something into a box. However, some hedge fund strategies do not fit into a box.
                                 There are many hedge funds, which do not fit into this classification and/or are
                                 hybrids of the above structure, ie, there are overlaps. However, for the purpose of
In Search of Alpha October 2000
                                  the description and performance analysis of the main styles (or skill-based strategies)
                                  the structure in Chart 4 is sufficient.

Correlation w ith equity          At the first level we distinguish between relative-value, event-driven and 'the rest'
m arket as m ain classifier       which we called 'opportunistic' in Chart 4. The main reason for this distinction is
                                  that relative-value had historically very little exposure/correlation to the overall
                                  market, whereas event-driven had little exposure/correlation and all other styles
                                  have variable degrees of exposure to the market.

Being long or flat the            We believe the main bone of contention in Chart 4 is probably the classification of
m arket is a big differe nce      long/short equity as opportunistic.' Long/short equity is the largest style in terms of
                                  number of managers pursuing the strategy. However, the managers in this group are
                                  not homogeneous. Some have long biases, others are market-neutral or short or vary
                                  over time. The managers in the long/short equity sub-style, who are close to market
                                  neutral are effectively pursuing a relative-value strategy and therefore are closer to
                                  the 'equity market neutral' camp. However, we justify the classification of eq uity
                                  long/short style as opportunistic because most managers have historically made the
                                  bulk of their gains on the long side, and, partly as a consequence, maintain net long

                                  In the following three chapters we highlight some of the main characteristics of the
                                  three styles and their sub-styles. A definition is given in the glossary on p173 for
                                  styles not covered here.

                                  1 For example, Schneew eis and Pescatore (1999) distinguish betw een five sectors (based on Evaluation
                                  Associates Capital Markets): relative value; event-driven; equity hedge; global asset allocators; and short
                                  selling. Long/short equity is a sub-sector of the relative value sector. It defines the equity hedge sector as
                                  long and short securities w ith varying degrees of exposure and leverage, such as domestic long equity
                                  (long undervalued US equities, short selling is used sparingly), domestic opportunistic equity (long and
                                  short US equities w ith ability to be net short overall), and global international (long undervalued global
                                  equities, short selling used opportunistically). We prefer our classification system because it allow s us to
                                  distinguish strategies w ith zero beta from the long-biased strategies.
InSearchofAlpha October2OOO

                                  Relative-Value and Market Neutral Strategies

                                  This class of investment strategy seeks to profit by capitalising on the mispricings of related
                                  securities or financial instruments. Generally, relative-value and market neutral strategies avoid
                                  taking a directional bias with regards to the price movement of a specific stock or market. We
                                  believe this makes this style most appealing for investors who are looking for high and stable
                                  returns accompanied by low correlation to the equity market.

Table 11: Sum m ary Risk/Return Characteristics Based on Historical Perform ance
  Sub-sector          Returns     Volatility   Dow nside     Sharpe      Correlation Exposure   Leverage Investm ent
                                                  risk        Ratio      to equities to m arket            Horizon
 Conv ertibles arbitrage Medium   Low        Low           Medium        Medium          Low         Medium         Medium
 Fixed income arbitrage Low       Low       Medium          Low           Low            Low          High          Medium
 Equity market-neutral Medium     Low        Low            High          Low            Low         Medium         Medium

Source: UBS Warburg

Exploiting inefficiencies for     Relative value and market-neutral strategies rely on identifying mispricings in
a living                          financial markets. A spread is applied when an instrument (equity, convertible
                                  bond, equity market, etc.) deviates from its fair value and/or historical norm.
                                  Relative value strategies can be based on a formula, statistics or fundamental
                                  analysis. These strategies are engineered to profit if and when a particular
                                  instrument or spread returns to its theoretical or fair value.

Hedged as in 'hedge funds'        To concentrate on capturing these mispricings, these strategies often attempt to
                                  eliminate exposure to significant outside risks so that profits may be realised if and
                                  when the securities or instruments converge towards their theoretical or fair value.
                                  The ability to isolate a specific mispricing is possible because each strategy should
                                  typically include both long and short positions in related securities. In most cases,
                                  relative-value strategies will likely seek to hedge exposure to risks such as price
                                  movements of the underlying securities, market interest rates, foreign currencies
                                  and the movement of broad market indices.

High risk-adjusted returns        Disciples of the efficient market hypothesis (EMH) argue that the con stant higher
could be derived from faulty      risk-adjusted returns of some hedge fund managers are derived from a faulty
m ethodology of accounting        methodology with respect to accounting for risk. Mean and variance do not fully
for risk                          characterise the return distribution and understate true risk of skewed returns with
                                  fat tails. On pp98-150 we examine mean and variance characteristics as well as
                                  non-normality features of the return distribution of the various hedge fund
                                  strategies. We conclude that changing the methodology does not change the
                                  conclusion with respect to superior risk-adjusted returns.

Convertible arbitrageurs          Another argument brought against some relative value strategies is that
m ade m oney in the 1929          opportunities are limited, ie, there is a capacity constraint. Hedge fund excess
crash                             returns will diminish as soon as a discipline reaches a capacity limit. With respect to
                                  capacity constraints, we would like to quote a market comment from 193 1:

                                  "The last few years have been marked by steadily increasing arbitrage
                                  opportunities and arbitrage profits. Between 1927 and 1930 alone over
In Search of Alpha October 2000
                      US$5bn worth of equivalent securities I were placed on the market. In the
                      same years the profits to the arbitrageurs totalled many millions of dollars.
                      The year 1929 was perhaps the most profitable year in arbitrage history,
                      but each year has yielded its quota of profits. Even the year 1930, which
                      was marked by steadily declining prices, yielded excellent profits.”2

“As long as there continue            We believe this market comment highlights two aspects, or, conversely, two
to be people like you, w e'll         misconceptions of investing in hedge funds. These are:
m ake m oney” 3
                                          (1)   Arbitrage is not a new concept. Mispriced derivatives and the exploitation of
                                                market inefficiencies by risk managers has been a feature of the industry for centuries;

                                          (2)   Relative-value strategies can do well in falling markets too. One of the
                                                criticisms is that hedge fund investing is a child of the current bull market and
                                                therefore a bubble about to burst. This does not seem likely. The 1929/30 period
                                                was the worst in US stock market history and arbitrageurs made money.
                                                The reason is that panic results in market inefficiencies. When the majority of
                                                the market participants panic, alternative money managers, eventually, make
                                                money. We will quantify correlation in down-markets later in the document.

                                          In this report we analyse three relative-value strategies, namely convertible
                                          arbitrage, fixed income arbitrage and equity market neutral strategies.

           security is a predecessor term for conv ertibles
I Equiv alent
2Frorn Weinstein (1931)
3Myron Scholes: "As long as there continue to be people like you, w e'll make money." See p66.
In Search of Alpha October 2000
                                  Convertibles Arbitrage

Exploiting market                 Convertible arbitrage is the trading of related securities whose future relationship
inefficiencies by hedging         can be reasonable predicted. Convertible securities are usually either convertible
equity, duration and credit       bonds or convertible preferred shares, which are most often exchangeable into the
risks                             common stock of the company issuing the convertible security. The managers in
                                  this category attempt to buy undervalued instruments that are convertible into
                                  equity and then hedge out the market risks. Fair value is based on the optionality in
                                  the convertible bond and the manager's assumption of the input variables, namely
                                  the future volatility of the stock.
                                  According to Tremont (1999), convertible arbitrage represents 3.5% of all funds
                                  and 4.4% of all assets under management. Nicholas (1999) estimates the assets
                                  under management in convertible arbitrage at only 1.8%.

Buying cheap volatility           Most managers view the discounted price of the convertible in terms of under-
                                  priced volatility, and use option-based models both to price the theoretical value of
                                  the instrument and to determine the appropriate delta hedge. The risk is that
                                  volatility will turn out lower-than-expected. Other managers analyse convertibles
                                  using cash flow-based models, seeking to establish positive carry positions
                                  designed to achieve a minimum level of return over their expected life.

                                  Although convertible arbitrage is technical (its basis for putting on a trade is a
                                  mathematical formula) it involves experience and the skill of its managers.
In Search of AlPha October 2000

                                  Interviewed in Mar/Hedge in February 1997, Gustaf Bradshaw, at the time director of resear ch of the
                                  BAH Funds, said:

                                            "The art of the convertible arbitrageur lies in the calculation of the
                                            amount of underlying equity that should be sold short against the local
                                            convertible position. This ratio can be adjusted depending on a manager's
                                            market view and so there is a large element of personal skill involved. This
                                            is an area where the skill and experience of the portfolio managers are
                                            vital because the computer systems are there to be overridden by the
                                            managers. Liquidity is one of the constraints in trading convertibles or
                                            warrants. You can often see great opportunities but no exit” 1

Running the delta high               In theory, convertible arbitrage is a relative value strategy. The concept f the classic trade is to
                                     exploit a market inefficiency. However, convertible arbitrageurs can hedge imperfectly and be
                                     long delta to express a view on the underlying market or stock. To some, the high risk-adjusted
                                     returns of convertible arbitrage are partially attributable to most convertible arbitrages having a
                                     positive delta in the bull market of the 1990s.

Leverage is betw een tw o-10:1       The degree of leverage used in convertible arbitrage varies significantly with the composition of
                                     the long positions and the portfolio objectives, but generally ranges between t wo and 10x
                                     equity. Interest rate risk can be hedged by selling government fond futures. Typical strategies

                                     -      Long convertible bond and short the underlying stock;

                                      -     Dispersion trade by being long volatility through the convertible bond positions and
                                      short index volatility through index options;

                                     -     Convertible stripping to eliminate credit risk;

                                      -    Arbitrating price inefficiencies of complicated convertible bonds and convertible preferred
                                      stocks with various callable, put-able, and conversion features (such as mandatory conversion,
                                      conversion factors based on future dividend payments, etc.);

                                      -    Buying distressed convertible bonds and hedging by selling short the underlying equity
                                           by hedging duration risk.

Cheap am                    An example of relative value disparity could be found in the capital structure of At
                                     the end of Q2 99, the Internet bookseller had, in addition to its equity capital, two tranches of
                                     long-term debt outstanding: a US$530m stepped-coupon senior debt isse of 2008 and a
                                     US$1.25bn convertible issue of 2009. After adjusting these securities’ prices to reflect market
                                     values at 30 June 1999, the following picture of the company’s capital structure emerged.

1 From Chandler (1998), p49.
In Search of Alpha October 2000

Buy low - sell high                         Despite no past earnings and no projected earnings for the fiscal year, equity
                                            holders believed the company to be extraordinarily valuable. The market
                                            capitalisation was US$20.2bn at 30 June 1999.1 The straight debt holders were
                                            somewhat less optimistic about's prospects, as implied by the yield
                                            spread of these securities and their credit rating. The yield spread had averaged
                                            about 450bp over comparable Treasuries, implying a significant element of risk.
                                            With the junior (equity) security holders euphoric and the senior security holders
                                            suspicious about the prospects of the company, one might have expected the middle
                                            tranche of convertible security holders to be 'cautiously upbeat'. Surprisingly, they
                                            were the most pessimistic stakeholders of all. Assuming 100% implied volatility,
                                            the credit spread was over 1,5001bp portending Amazon's imminent demise. Viewed
                                            differently, with a normalised credit spread of 600bp, the convertible was trading at
                                            a very low level of implied stock volatility. Either the convertible was too cheap or
                                            equity too expensively valued by the market. To exploit this inefficiency,
                                            convertible arbitrageurs sold expensive equity and bought the comparably cheap
                                            convertible bond.

If the stock falls sharply the              Although the above example seemed to be a 'no-brainer' example of convertible
price of the convertible                    arbitrage, investors who put on the trade without hedging the credit risk have lost
bond can becom e a                          money to date (September 2000). The convertible bond fell more or less in line with
function of the credit rating               the stock. As Internet stocks fell in Q2 00, the markets' assessment of the credit
                                            rating of these stocks fell as well. The companies were said to be 'burning cash'.
                                            This resulted in the synthetic put of the convertible bond to lose value. In other
                                            words, the value of the convertible bond became more a function of the straight
                                            debt value (bond floor) and less a function of the conversion value. The recent path
                                            of the arbitrage is therefore not only a good example of the mechanics
                                            of convertible arbitrage, it also highlights that convertibles can behave more as

    Which compares with US$12.8bn one year later.
In Search of Alpha October 2000

                                  straight bonds after a dramatic fall of the share price, when the convertible bond becomes a
                                  function of credit risk as opposed to equity risk.

Exchangeables have low er          A profitable example of convertible arbitrage is the purchase of the Siemens
credit risk                       Exchangeable 2005 (exchangeable into Infineon stock) and the sale of Infineon
                                  stock. The attraction of exchangeables for spin-offs, such as Infineon by Siemens, is
                                  that the convertible bond carries the credit risk of the issuer (the blue-chip mother
                                  company), which in this case is Siemens, and allows the spin-off to finance itself
                                  more cheaply than if it issued a plain-vanilla convertible bond. We believe there
                                  will be an increase in issuance of exchangeable convertible bonds since it is an
                                  attractive financing instrument for companies unwinding cross -holdings or spinning
                                  off subsidiaries.
In Search of Alpha October2OOO

                                 Fixed Income Arbitrage

Exploiting m arket               Fixed income arbitrage managers seek to exploit pricing anomalies within and
inefficiencies in the fixed      across global fixed income markets and their derivatives, using leverage to enhance
incom e m arket                  returns. In most cases, fixed income arbitrageurs take offsetting long and short
                                 positions in similar fixed income securities that are mathematically, fundamentally
                                 or historically interrelated. The relationship can be temporarily distorted by market
                                 events, investor preferences, exogenous shocks to supply or demand, or structural
                                 features of the fixed income market. According to Tremont (1999), fixed income
                                 arbitrage represents 5.1 % of all funds and 7.7 % of all assets under management.

Credit anom alies and            Often, opportunities for these relative value strategies are the result of temporary
advantageous financing           credit anomalies, and the returns are derived from capturing the credit anomaly and
                                 obtaining advantageous financing. These strategies can include:
                                 • Arbitrage between physical securities and futures (basis trading);
                                 • Arbitrage between similar bonds in the same capital structure;
                                 • Arbitrage pricing inefficiencies of asset backed securities, swaptions, and other
                                      interest rate financial instruments;
                                 • Arbitrage between on-the-run and off-the-run bonds (issuance-driven trade);
                                 • Arbitrage between liquid mutual funds containing illiquid municipal bonds with
                                      treasury bonds;
                                 • Yield curve arbitrage and yield curve spread trading;
                                 • Stripping bonds with multiple callable features or swaps with complicated cash
                                      flows into their components in order to arbitrage these stripped components;
I n Search of Alpha October 2000
                                   - Exploitation of inter-market anomalies (buying 'TED' spread by being long
                                     Treasury bill futures and short Eurodollar futures under the assumption that the
                                     spread will widen).

High degree of                     Because the prices of fixed income instruments are based on yield curves, volatility
sophistication                     curves, expected cash flows , credit ratings, and special bond and option features,
                                   fixed income arbitrageurs must use sophisticated analytical models to identify
                                   pricing disparities and to manage their positions. Given the complexity of the
                                   instruments and the high degree of s ophistication of the arbitrageurs, the fixed
                                   income arbitrageurs rely on investors less sophisticated than themselves to over-
                                   and under-value securities by failing to value explicitly some feature on the
                                   instrument (for example, optionality) or the probability of a possible future
                                   occurrence (for example, political event) that will likely affect the valuation of the
                                   instrument. The alpha of a fixed income hedge fund, therefore, is primarily derived
                                   from the skill needed to model, structure, execute and manage fixed income

Sm all m argin, high leverage      The spreads available tend to be very small, of the order of three to 20bp.
                                   Therefore, managers need to lever the position and expect to make money out of
                                   carry on the position and the spread reverting to its normal level. In order to
                                   generate returns sufficient to exceed the transaction costs, leverage may range from
                                   20 to 30x NAV employed. Despite the high leverage, the volatility of returns
                                   achieved by fixed income arbitrageurs is usually very low due to the market-neutral
                                   stance of most funds in this discipline.

Not all fixed incom e              In general, fixed income arbitrageurs aim to deliver steady returns with low
arbitrage strategies are           volatility, due to the fact that the directional risk is mitigated by hedging against
m arket-neutral                    interest rate movements, or by the use of spread trades. Managers differ in terms of
                                   the diligence with which interest rate risk, foreign exchange risk, inter-market
                                   spread risk, and credit risk is hedged.' Leverage depends on the types of positions
                                   in the portfolio. Simple, stable positions, such as basis trades, are leveraged much
                                   more highly than higher risk trades that have yield curve exposure. Some managers
                                   take directional credit spread risk, which results in a violation with our 'relative
                                   value' definition stated above. Some observers, due to large, unexpected losses in
                                   yield curve arbitrage in 1995, have also concluded that some trades with exposure
                                   to changes in the yield curve are not market-neutral (White 1996).

Basis trading as an exam ple       Basis trading is the most basic fixed income arbitrage strategy. A basis trade
of fixed incom e arbitrage         involves the purchase of a government bond and the simultaneous sale of futures
                                   contracts on that bond. Bond futures have a delivery option, which allows several
                                   different bonds to be delivered to satisfy the futures contract. Because it is not
                                   certain which bond is expected to become the cheapest to deliver at matu rity, this
                                   uncertainty, along with shifts in supply and demand for the underlying bonds, may
                                   create profit opportunities.

                                   1   Pension & Endow ment Forum (2000), p23.
In Search of Alpha October 2000
Attractive opportunities          There were particularly attractive opportunities in this segment with the exodus of several
Post-LTCM                         proprietary trading desks and the downscaling of activities by other market
                                  participants such as LTCM. One situation in Brazilian fixed income instruments provides an
                                  interesting example of the inefficiencies in this area. The Brazilian sovereign market consists of
                                  many related securities, two of which are New Money Bonds and the Eligible Interest Bonds.
                                  Because New Money Bonds are somewhat less liquid then Eligible Interest Bonds they tend to
                                  react more slowly to changes in Brazilian fundamentals. During a rally in bonds in March 1999,
                                  for example, it was possible to purchase the lagging New Money Bonds at 55 and sell the
                                  Eligible Interest Bonds at 65, taking the 10-point credit differential, while picking up 125bp
                                  in yield. In either a bullish or bearish scenario, the trade was compelling: a deteriorating market
                                  would tend to cause the prices of both bonds to converge as a restructuring scenario unfolded;
                                  while (as it turned out) in a bullish market the money flows bid up the price of the New Money
                                  Bonds. Profits were taken as the prices converged to more normal levels.
In Search of Alpha October 2000

                                            Equity Market-Neutral

             The goal is consistent         Equity market-neutral is designed to produce consistent returns with very low
             returns w ith low volatility   volatility and correlation in a variety of market environments. The investment
             and low correlation            strategy is designed to exploit equity market inefficiencies and usually involves
                                            being simultaneously long and short matched equity portfolios of the same size
                                            within a country. Market neutral portfolios are designed to be either beta or
                                            currency-neutral or both. Equity market-neutral is best defined as either statistical
                                            arbitrage or equity long/short with zero exposure to the market. According to
                                            Tremont (1999), equity market neutral represents 3.8% of all funds and 3.9% of all
                                            assets under management.

             Num ber crunching can add      Quantitative long/short funds apply statistical analysis to historical data (historical
             value                          asset prices as well as 'fundamental' or accounting data) to identify profitable
                                            trading opportunities. The traditional discipline entails hypothesising the existence
                                            of a particular type of systematic opportunity for unusual returns, and then
                                            'backtesting' the hypothesis. Backtesting essentially entails gathering the historical
                                            data and performing the calculations on it necessary to determine whether the
                                            opportunity would have been profitable had it been pursued in the past. Simple
                                            hypotheses are preferred to complex hypotheses; the intricate trading rules favoured
                                            by technicians and chartists are generally avoided. Normally, analysts hope to
                                            bolster their empirical findings with intuitive explanations for why the hypothesised
                                            opportunity should exist. Once a successful strategy is identified, it is normally
                                            implemented relatively mechanically. That is, the strategy is traded according to a
                                            limited set of clearly defined rules (the rules that were backtested), which are only
                                            rarely overridden by the subjective judgement of the manager. 'Quant' fund
                                            strategies are often closely related to work published by finance academics in peer
                                            reviewed academic journals. In many cases, the fund managers come from
                                            academic backgrounds and, in some cases, created the academic research
                                            themselves. Quant fund managers are often very secretive, as their trading rules are
                                            potentially prone to theft. Mean reversion and earnings surprises have been the
                                            main drivers of this strategy.

              Risk control Is im portant        Users of quantitative strategies expect to identify small but statistically significant
                                                return opportunities, often across large numbers of stocks. Quantitative managers
                                                typically balance their longs and shorts carefully to eliminate all sources of risk
                                                except those that they expect will create returns. Since they are often trading long
                                                portfolio lists, they are able to reduce dramatically not only broad market risk, but
                                                also industry risk, and aggregate stock-specific risk. They appear less likely than
                                                fundamental managers to adopt substantial long or short biases.
                                                equity market-neutral fund, however, can generate alpha by buying stock as well as

             Double alpha                       One of the great advantages of equity market-neutral strategies is the doubling of
                                                alpha. A long-only manager who is restricted from selling short only has the
                                                opportunity to generate alpha by buying or not buying stocks. A manager of an
                                                selling stock short. Some market observers argue that this 'double alpha' argument
                                                is faulty because an active long-only manager can over- and underweight securities,
                                                which means he is short relative to benchmark when underweight. We do not share
                                                this view because we believe there is a difference between selling short and being
                                                underweight against a benchmark. If a stock has a weight of 0.02% in the
In Search of Alpha October 2000

                                  benchmark index, the possible opportunity to underweight is limited to 0.02% of the portfolio.
                                  We would even go as far as portraying short selling as a risk management discipline of its own.
                                  We will address this issue on p76 where we attempt to de-mystify short selling.

A pair trade involves the         A typical example in this category would be a pair trade where one share category
purchase of One share             of the same economic entity is bought and the other is sold. One example of such a
category and the sale of          pair trade is the unification of shares of Zurich Financial Services of Switzerland,
another on the same stock
                                  which announced a merger with the financial services arm of BAT Industries of the
                                  UK. This pair trade is typical for equity market-neutral managers because it does
                                  not involve market or sector risk. The two stocks are based on the same economic
                                  entity, which happen to deviate in price. Other typical pair trades involve trading
                                  voting rights, for example, buying TIN4 savings shares and selling the ordinary

The law of one price is the       For legal reasons two share categories were listed, Allied Zurich in the UK and
underlying theme of most          Zurich Allied in Switzerland. Each Allied Zurich share was entitled to receive 0.023
equity market-neutral trades      Zurich Allied shares. On 17 April, Zurich Financial Services announced the
                                  unification of their two shares that was sweetened with a 40p dividend for
                                  shareholders in Allied Zurich. The spread narrowed to zero by September 2000.
                                  The fact that Zurich Allied and Allied Zurich were not traded at the same price was
                                  a violation of the law of one price since both shares together made up Zurich
                                  Financial Services.

                                  This concludes our description of the three strategies in the relative value arena. In
                                  the following section, we discuss the characteristics of two event-driven strategies,
                                  risk arbitrage and distressed securities.
In Search of Alpha October 2000

                                     Event-Driven Strategies

                                                                                   "We are ready for an unforeseen event that may or
                                                                                   may not occur. " Dan Quayle

Returns generated                    This investment strategy class focuses on-identifying and analysing securities that
independently from m oves            can benefit from the occurrence of extraordinary transactions. Event-driven
in the stock m arket                 strategies concentrate on companies that are, or may be, subject to restructuring,
                                     takeovers, mergers, liquidations, bankruptcies, or other special situations. The
                                     securities prices of the companies involved in these events are typically influenced
                                     more by the dynamics of the particular event than by the general appreciation or
                                     depreciation of the debt and equity markets. For example, the result and timing of
                                     factors such as legal decisions, negotiating dynamics, collateralisation requirements,
                                     or indexing issues play a key element in the success of any event-driven strategy.
                                     According to Tremont (1999), event-driven strategies represent 11.9% of all funds
                                     and 16.6% of all assets under management.

Table 14: Sum m ary Risk/Return Characteristics Based on Historical Perform ance
  Sub-sector        Returns      Volatility   Dow nside     Sharpe     Correlation Exposure    Leverage Investm ent
                                                 risk        ratio      to equities to m arket            horizon
 Risk arbitrage        High       Medium       Medium        High         Medium        Medium        Medium        Medium
 Distressed securitiesMedium      Medium       Medium       Medium        Medium        Medium         Low           Long

Source: UBS Warburg

Research intensive                 Typically, these strategies rely on fundamental research that extends beyond the
strategies                         evaluation of the issues affecting a single company to include an assessment of the
                                   legal and structural issues surrounding the extraordinary event or transaction. In
                                   some cases, such as corporate reorganisations, the investment manager may actually
                                   take an active role in determining the event's outcome.

Opportunities for high risk -      The goal of event-driven strategies is to profit when the price of a security changes
adjusted returns even in flat      to reflect more accurately the likelihood and potential impact of the occurrence, or
or negative m arkets               non-occurrence, of the extraordinary event. Because event-driven strategies are
                                   positioned to take advantage of the valuation disparities produced by corporate
                                   events, they are less dependent on overall s tock market gains than traditional equity
                                   investment approaches.

Event-driven strategies            In times of financial crisis, the correlation between event-driven strategies and
have higher system atic risk       market activity can increase to uncomfortable levels. During the stock market crash
than relative value                in October 1987, for example, merger arbitrage positions fell in step with the
strategies                         general market, providing little protection in the short run against the dramatic
                                   market decline (Swensen 2000). As time passed, investors recognised that
                                   companies continued to meet contractual obligations, ultimately completing all
                                   merger deals previously announced. The return of confidence improved merger
                                   arbitrage results, providing handsome returns relative to the market.
In Search of Alpha October 2000
                                      Risk Arbitrage

Bet on a deal being                   Risk arbitrage (also known as merger arbitrage) specialists invest simultaneously in
accepted by regulators and            long and short positions in both companies involved in a merger or acquisition. In
shareholders                          stock swap mergers, risk arbitrageurs, are typically long the stock of the company
                                      being acquired and short the stock of the acquiring company. In the case of a cash
                                      tender offer, the risk arbitrageur is seeking to capture the difference between the
                                      tender price and the price at which the target company's stock is trading.

Deal risk is usually                  During negotiations, the target company's stock can typically trade at a discount to
uncorrelated w ith m arket            its value after the merger is completed because all mergers involve some risk that
risk                                  the transaction will not occur. Profits are made by capturing the spread between the
                                      current market price of the target company's stock and the price to which it will
                                      appreciate when the deal is completed or the cash tender price. The risk to the
                                      arbitrageur is that the deal fails. Risk arbitrage positions are considered to be
                                      uncorrelated to overall market direction with the principal risk being 'deal risk'.

We live in a probabilistic            Former US secretary of the Treasury and Goldman Sachs partner, Robert Rubin
w orld                                brought fame to the profession in the 1980s. Throughout the industry, Rubin was
                                      known as one of the best in the field (Endlich 1999). His careful research and
                                      unemotional trading style were legendary. A quote from Rubin emphasises what
                                      risk arbitrage is all about:

                                            "If a deal goes through, what do you win? If it doesn't go through, what do
                                            you lose? It was a high-risk business, but I'll tell you, it did teach you to
                                            think of life in terms of probabilities instead of absolutes. You couldn't be
                                            in that business and not internalise that probabilistic approach of life. It
                                            was what you were doing all the time.

Regulatory risk is key                Risk arbitrageurs differ according to the degree to which they are willing to take on
                                      deal risk. Where antitrust issues are involved, this risk is often related to regulatory
                                      decisions. In other cases, as was predominant in the late 1980s, financing risk was
                                      the major concern to arbitrageurs. Most managers only invest in announced
                                      transactions, whereas a few are likely to enter positions with higher deal risk and
                                      wider spreads based on rumour or speculation.

Table 15: Key Risk Factors
Risk     Position                               Effect

 Legal Trust regulation               Risk arbitrage is primarily a bet on a deal being accepted by regulators and shareholders. If a deal Is
                                      called off, the risk arbitrageur usually loses as the spread w idens.

 Equity Short delta, long liquidity   One of the main performance v ariables is liquidity. Merger arbitrage returns depend on the ov erall
        and long volatility           v olume of merger activ ity, w hich has historically been cyclical in nature.

                                      In general, strategy has exposure to deal risk and stock specific risk, w hereas market risk is often
                                      hedged by inv esting in 10-20 deals. Stock specific risk has a large cap bias since large caps are easier
                                      to soil short.

                                      Most trades are transacted on a ratio-basis as opposed to a cash-neutral basis assuming the spread
                                      conv erges. This leav es the arbitrageur w ith a small short delta position as the cash outlay for long stock
                                      position is smaller than the proceeds from the short position.

Source: UBS Warburg                   _______________________
                                      1From Endlich (1999). p109.
In Search of Alpha October2000

Sub-sector in itself is          Most managers use some form of 'risk of loss' methodology to limit position size,
heterogeneous                    but risk tolerance reflects each manager's own risk/return objectives.' Some
                                 managers simply maintain highly diversified portfolios containing a substantial
                                 Portion of the transaction universe, typically using leverage to enhance returns,
                                 whereas other managers maintain more concentrated portfolios (often unleveraged)
                                 and attempt to add value through the quality of their research and their ability to
                                 trade around the positions. Some managers are more rigorous than others at hedging
                                 market risk.

Risk arbitrage is not sim ply    Given the high profile of recent risk arbitrage deals and their profitability to the
a binary event                   arbitrageur, many long-only managers joined this discipline. We believe that there
                                 is a certain risk of this herd behaviour backfiring. There is more to risk arbitrage
                                 than simply buying the stock of the company being acquired and selling the stock of
                                 the acquiring company. Risk arbitrage is not simply a binary event, will it work or
                                 fail? Risk arbitrage, as the name implies, is more the task of the risk manager than
                                 that of a portfolio manager. The deals are most often highly complex an d the
                                 management of unwanted risk requires knowledge, experience and skill in all
                                 financial engineering and risk management disciplines. Below we list just a
                                 selection of the tasks, which are carried out by risk arbitrageurs entering a spread:

                                   • Analysis of public information regarding the companies of the transaction and
                                     the markets in which they compete, including company documents, various
                                     industry and trade data sources, past Justice Department or Federal Trade
                                     Commission enforcement activities in the relevant product and geographic
                                     markets, and current antitrust agency enforcement policies;

                                   • Estimation of probabilities as to the likelihood of a government antitrust
                                     investigation and enforcement action, the likely outcome of such an action, and
                                     whether a remedial order can be negotiated eliminating the necessity for

                                   • Monitoring of litigation by the government and any private enforcement action
                                     and, in hostile transactions, analysis of the viability on antitrust and regulatory
                                     grounds of possible white knight candidates; analysis of the requirements and
                                     procedures of various federal and state regulatory approvals that may be
                                     required, depending upon the nature of the acquired company's business

                                   • Control of deal risk with respect to the acquiror walking away, deal delay,
                                     possibility of material adverse conditions, shareholder approval, tax
                                     implications, and financing conditions; and

                                   • In hostile transactions, analysis of the viability of various anti-takeover devices
                                     created by the target corporation in anticipation of or in the course of the
                                     unwanted takeover attempt and litigation arising from these defences.

                                    1 Pension & Endow ment Forum (2000), p28.
In Search of Alpha October2000

Risk arbitrage has a long               Risk arbitrage is not new. As a matter of fact, risk arbitrage has a long tradition.
tradition                               Two prominent arbitrageurs, Gus Levy and Cy Lewis, were instrumental in
establishing Goldman Sachs and Bear Stems as prominent Wall Street firms. Gus
Levy invented risk arbitrage in the 1940s and Ivan Boesky popularised it 40 years
                                        later (Endlich 1999). In fact, the senior post at Goldman Sachs has traditionally
                                        been filled by the head of the 'arb desk' including former US secretary of the
                                        Treasury Bob Rubin. Risk arbitrage was Goldman Sachs's second most profitable
                                        department after mergers and acquisitions, it was regarded as a jewel in the firm's
                                        crown. Risk arbitrage received negative press coverage in the late 1980s when some
                                        well known 'M&A specialists', such as Ivan Boesky and Martin Siegel, bought
                                        stock in companies before the merger announcements using inside informat ion and
                                        Robert Freeman, chief of risk arbitrage, head of international equities, and trusted
                                        partner of Goldman Sachs, was forced to step down in ignominy.

Exam ple                               An illustrative and successful example of risk arbitrage activity is the completion of
                                       the acquisition of Mannesmann by Vodafone AirTouch.

                                        The deal was announced on Sunday 14 November 1999, when Vodafone AirTouch bid 53.7 of
                                        its own shares for each Mannesmann share. At the close of the following Monday, the bid
                                        premium was 22.5%. On 4 February, the Vodafone AirTouch board approved an increase bid of
                                        58.9646 shares for each Mannesmann share. On 10 February, the deal was declared wholly
                                        unconditional. The bid premium eventually melted to zero, resulting in a large profit for hedge
                                        funds, which sold stock of the acquiror and simultaneously bought stock of the target
In Search of Alpha October 2000

                                            Distressed Securities
              Distressed securities is      Distressed securities funds invest in the debt or equity of companies experiencing
              about being long low          financial or operational difficulties or trade claims of companies that are in financial
              investm ent grade credit      distress, typically in bankruptcy. These securities generally trade at substantial
                                            discounts to par value. Hedge fund managers can invest in a range of instruments
                                            from secured debt to common stock. The strategy exploits the fact that many
                                            investors are unable to hold below investment grade securities.

              origins go back to 1890s      Distressed securities have a long tradition. The origins of these event -driven
                                            strategies probably go back to the 1890s when the main railways stocks were

                                            folding. Investors bought the cheap stock, participated in the restructuring and
                                            issuance of new shares and sold the shares with a profit.

              Distressed securities are     Distressed securities often trade at large discounts since the sector is mainly a
              under-researched and          buyer's market (Cottier 1996). Most private and institutional investors want to get
              distressed securities funds   securities of distressed companies off their books because they are not prepared to
              have a strong long-bias       bear the risks and because of other non-economic issues. Distressed companies are
                                            barely covered by analysts. Most banks do not get involved in the distressed
                                            securities business. Many distressed securities funds are long only.

              Fundam ental versus           Distressed securities specialists make investment returns on two kinds of
              intrinsic value               mispricings. First, fundamental or intrinsic value, which is the actual value of the
                                            company that the bond interest represents. Second, relative-value, which is the
                                            value of bonds relative to the value of other securities of the same company
                                            (Nicholas 1999). When the market price of a company's security is lower than its
                                            fundamental value due to temporary financial difficulties, distressed securities
                                            specialists will take core positions in these securities and hold them through the
                                            restructuring process. They believe that the security will approach its fair value after
                                            the restructuring is complete.

              Capital structure arbitrage   While a company is restructuring, the prices of its different financial instruments
                                            can become mispriced relative to one another. This is an opportunity for what is
                                            referred to as intra-capitalisation or capital structure arbitrage. The distressed
                                            securities specialists purchase the undervalued security and take short trading
                                            positions in the overpriced security to extract an arbitrage profit.
In Search of Alpha October 2000

Usually low leverage and          The main risks of distressed securities investing lie in the correct valuation of
low volatility                    securities, debt and collateral, as well as in the adequate assessment of the period
                                  during which the capital will be tied up (taking into account major lawsuits, etc.).
                                  Sometimes other asset classes are shorted in order to offset a part of the risks, and
                                  guarantees or collateral (such as brand names, receivables, inventories, real estate,
                                  equipment, patents, etc.) are used to hedge the risks. The diversification between
                                  securities, companies, and sectors is very important. Distressed funds have typically
                                  low leverage and low volatility. However, since positions are extremely difficult to
                                  value, investors have to bear mark-to-market risk. The volatility of the returns is
                                  therefore probably higher than published. The prices of distressed securities are
                                  particularly volatile during the bankruptcy process because useful information about
                                  the company becomes available during this period.

Long term in nature               Investments in distressed securities are most often illiquid. Long redemption
                                  periods, therefore, are the norm. Frequent liquidity windows of one year or more
                                  (for example quarterly) work against the nature of the strategy. A hedge fund
                                  manager will seek a long-term commitment from his investors. It is essential that
                                  the manager has a large pool of committed capital so that liquidity is not a problem.
                                  The length of any particular bankruptcy proceeding is notoriously hard to forecast
                                  and the outcome is always uncertain, both of which make the duration of distressed
                                  securities strategies unpredictable. In addition, managers who participate on creditor
                                  and equity committees must freeze their holdings until an arrangement is reached.

Active versus passive             There are basically two different approaches. Active distressed managers get
approach                          involved in the restructuring and refinancing process through activ e participation in
                                  creditor committees. In some cases, an investor may even actively reorganise the
                                  company. The passive approach simply buys equity and debt of distressed
                                  companies at a discount and holds onto it until it appreciates. Both approaches a re
                                  very labour-intensive and require a lot of analytical work. The US bankruptcy law
                                  is very detailed. Chapter 11 of the US Bankruptcy Code provides relief from
                                  creditor claims for companies in financial distress. Large tax loss carry forwards,
                                  strict disclosure rules, and clear debt restructuring rules help in reorganising
                                  distressed companies. The objective is to save distressed companies from total
                                  liquidation (Chapter 7). In Europe, however, bankruptcy is intended to end and not
                                  prolong the life of a company. US distressed securities markets are therefore much
                                  more liquid than their European counterparts, which is why few distressed funds are
                                  active outside the US. Typical trades are:

Typical trades                    • Entering into core positions in the debt and equity of a distressed company,
                                      accompanied by active participation in the creditor committees in order to
                                      influence the restructuring and refinancing process;

                                  • Passive long-term core positions in distressed equity and debt;

                                  • Short-term trading in anticipation of a specific event such as the outcome of a
                                      court rule or important negotiations;

                                  • Partial hedging of the stock market and interest rate exposure by shorting other
                                      stocks of the same industry or by shorting Treasury bonds.
In Search of Alpha October 2000

                                  -Arbiraging different issues of the same distressed company (eg, long mezzanine debt and short
                                   common stock);

                                  -Vulture investing (derogatory term applied when a venture capitalist or a distressed securities
                                    investor gets an unfairly large equity stake);

                                  -Providing buy-out capital: equity or debt for privatizations, spin-offs, acquisitions and takeovers
                                   (often by the firm’s own management). Buy-out capital may be leveraged.

                                  This concludes our description of event-driven strategies. In the following section we describe
                                  four strategies which we summarise as ‘opportunistic strategies’ namely macro funds, short sellers,
                                  long/short equity and emerging markets.
In Search of Alpha October 2000

                                        Opportunistic Strategies

                                                                                       "I don't play the game by a particular set of rules;
                                                                                       I look for changes in the rules o the game."
George Soros1

Strategies which are not                The main section of this report is a detailed analysis of hedge fund historical risk
dependent on market                     and return characteristics (starting p98). Despite having some reservations
returns are more easily                 regarding to the quality of the hedge fund index return data, we analysed time serie s
forecasted                              to assess how these characteristics could be defined in the future. For this reason,
                                        we classified the hedge fund universe in three main groups - relative-value and
                                        non-relative-value plus a hybrid of the two. The key determinant for our
                                        classification is exposure to the market. In our opinion, an investor that understands
                                        where risk and returns in convertible arbitrage are generated should have the tools
                                        to extrapolate the return, risk and correlation characteristics into the future. The
                                        predictability of performance characteristics increases as market exposure
                                        decreases, ie, increases if we go from right to left in Chart 9.

Other classification systems distinguish between directional and non -directional at the first level instead of relative-value, event-driven
and opportunistic. With such a

1   From Nicholas (1999), p172.
In Search of Alpha October 2000

                                           classification, risk arbitrage would be defined as non-directional, whereas distressed securities
                                           as directional. Chart 9 would justify such a classification system as the dispersion of returns of
                                           risk arbitrage are much lower than for distressed securities which have a strong directional bias.

Table 17: Sum m ary Risk/Return Characteristics Based on Historical Perform ance
 Sub-sector          Returns      Volatility     Dow nside       Sharpe       Correlation    Exposure       Leverage     Investment
                                                   risk           ratio       to equities    to market                     horizon

 Macro                High          High           Medium        Medium        Medium          High         Medium         Short
 Short sellers        Low           High            High          Low          Negative        High          Low          Medium
 Long/short equity    High          High            High          Low            High          High          Low           Short
 Emerging markets     High          High            High           Low           High          High           Low          Medium

Source: UBS Warburg

Higher volatility and low er             The main difference between the four opportunistic strategies in Table 17 and the
risk-adjusted returns                    previously discussed relative value and event-driven strategies is volatility and the
                                         exposure to the market. The high volatility is primarily a function of beta, ie, a high
                                         exposure to the underlying asset class. As a result of higher volatility, risk-adjusted
                                         returns (as measured for example with the Sharpe ratio) are lower then with relative
                                         value and event-driven strategies.
In Search of Alpha October2OOO


Macro funds have the                         Macro hedge funds, also known as 'Global macro funds', enjoy extraordinary
flexibility to m ove from                    flexibility regarding investment policy and investment strategies. They are (or were)
opportunity to opportunity                   the big players of the hedge fund industry and the ones most often in the headlines.
w ithout restriction                         They are (or have been) regarded as the new trading and investment gurus (Cottier
                                             1996). Through their size and leverage, they are believed to influence and
                                             manipulate markets. Some macro hedge funds were accused of causing the fall in
                                             the pound sterling in 1992, resulting in its withdrawal from the European Monetary
                                             System. However, this allegation was brought into question by a study published by
                                             the, International Monetary Fund! Furthermore, it can be argued that since every
                                             move by one of the big macro players is amplified by many smaller copycats, they
                                             may not be entirely to blame for their large impact. For this reason, macro funds no
                                             longer disclose their positions, a move that has diminished the already low
                                             transparency of these funds.

Opportunistic strategies                     Macro hedge funds pursue a base strategy such as equity long/short or futures trend
                                             following to which large scale and highly leveraged directional bets in other
                                             markets are added a few times each year. They move from opportunity to
                                             opportunity, from trend to trend, from strategy to strategy. According to Tremont
                                             (1999), in 1998 4.0% of all funds are in this category, representing 14.9% of all
                                             assets under management.

The higher the m arket                       Most often macro funds operate in very liquid and efficient markets such as fixed
efficiency the few er                        income, foreign exchange or equity index futures markets. We believe there is a
opportunities exist                          trade-off between liquidity and opportunity. Liquidity is correlated with efficiency.
                                             The more efficient a market the higher the liquidity. High liquidity and high
                                             efficiency often means close to perfect information and competition. Perfect
                                             information and perfect competition means fewer opportunities to exploit
                                             inefficiencies. Macro funds, therefore, make their money by anticipating a price
                                             change early and not by exploiting market inefficiencies.

Macro m anagers exploit far-                 Macro fund managers argue that most price fluctuations in financial markets fall
from -equilibrium conditions                 within one standard deviation of the mean (Nicholas 1999). They consider this
                                             volatility to be the norm, which does not offer particularly good investment
                                             opportunities. However, when price fluctuations of particular instruments or
                                             markets push out more than two standard deviations from the mean into the tails of
                                             the bell curve, an extreme condition occurs that may only appear once every two or
                                             three decades. When market prices differ from the 'real' value of an asset, there
                                             exists an investment opportunity. The macro investor makes profits by exploiting
                                             such extreme price/value valuations and, occasionally, pushing them back to normal

1 It is beyond doubt that macro hedge funds had a significant short position in sterling in  1992 that impacted the market. It is, however, difficult to
determine whether this position 'caused' the sterling devaluation, because it coincided with net capital outflows from the UK . The prologue to the 1992 ERM
crisis was the 'conversion' play, estimated to be aroundUS$300bn by the IMF. Altogether, European central bank interventions amounted to roughly
US$100bn. The US$11.7bn in hedge fund positions coincided with at least another US$90bn of sales in European currencies. We e xplode the myth of hedge
funds causing world-wide havoc on p78.
In search of Alpha October2OOO

Stock picking versus risk             Tremont (1999) distinguished two kinds of macro managers, those who come from
m anagem ent background               a long/short equity background and those who come from a derivative trading

(1)      Macro funds run by companies like Tiger Investment Management and
                                              Soros Fund Management were originally invested primarily in US equities.
                                              The success of these managers at stock picking resulted over time in
                                              substantial increases in assets under management. As the funds increased in
                                              size, it became increasingly difficult to take meaningful positions in
                                              smaller-capitalisation stocks. Consequently, the funds started gravitating
                                              towards more liquid securities and markets in which bigger bets could be

(2)      Funds run by Moore Capital, Caxton, and Tuder Investment developed
                                              from a futures trading discipline which, by its very nature, was both global
                                              and macroeconomic in scope. The freeing up of the global currency
                                              markets and the development of non-US financial futures markets in the
                                              1980s provided an increasing number of investment and trading
                                              opportunities not previously available to investment managers.

Mouse clicks and                      Anecdotal evidence suggests that the latter do better than the former in market
m om entum                            stress situations as witnessed in March/April 2000. Julian Robertson wrote to
                                      investors in March 2000 to announce the closure of the Tiger funds. Investors are
                                      expected to get 75% back in cash and 5% in a basket of securities. The 20% balance
                                      will likely stay in five stocks, the returns on which should eventually be reimbursed
                                      to investors. In total he is returning US$6.5bn to investors. Robertson said that,
                                      since August 1999, investors had withdrawn US$7.7bn in funds. He blamed the
                                      irrational market for Tiger's poor performance, saying that "earnings and price
                                      considerations take a back seat to mouse clicks and momentum." Robertson
                                      described the strength of technology stocks as "a Ponzi pyramid destined for
                                      collapse." Robertson's spokesman said that he did not feel capable of figuring out
                                      investment in technology stocks and no longer wanted the burden of investing other
                                      people’s money. Ironically, his letter reached investors in the week that the
                                      NASDAQ plunged and his views were being proved right. The Tiger funds were up
                                      6% in March and US Air, the biggest of Robertson's remaining five holdings, has
                                      seen a 30% gain within two weeks as old economy stocks came back into fashion.

The death of the m acro               Tiger Management's large losses and George Soros' retreat are potentially a sign
fund?                                 that the heyday of macro funds is over. At the end of April 2000, George Soros
                                      announced that he was cutting back on his Quantum fund. Quantum had US$8.5bn
                                      in assets when Soros made the announcement that Stanley Druckenmiller, the
                                      manager of the fund, and his colleague Nicholas Roditi, who ran the US$1.2bn
                                      Quota Fund, were leaving the group. The Quantum fund, which will be renamed
                                      Quantum Endowment Fund, plans to stop making large, so-called macro bets on the
                                      direction of currencies and interest rates and expects to target an annual return of
                                      15% which is less than half of the annual average posted since the fund's start in
                                      1969. One month later, the Quantum fund was said to have 90% in cash according
                                      to Bloomberg.
In Search of Alpha October 2000
                                                   Trades of the magnitude of George Soros' sterling trade in 1992 might or might not
Opportunistic funds have a                         belong in the past. However, we believe the opportunistic hed ge fund which has a
future despite setbacks in                         mandate to invest in anything the general partners believe to yield a profit, will
H1 00                                              continue to raise funds in the future. Whether an investor prefers the stable, highly
                                                   predictable returns of relative-value strategies or the unpredictable, widely
                                                   dispersed and erratic returns generated by opportunistic funds, is a matter of
                                                   idiosyncratic preference. We believe that an over-funded pension fund would be
                                                   inclined to favour the former over the latter. However, we believe opportunistic
                                                   hedge funds such as global macro or global asset allocation funds are not as dead as
                                                   some claim them to be.

                                                   The next opportunistic investment style we discuss in this report is short selling. For
                                                   a very brief moment in spring 2000, it looked like short sellers would experience a
                                                   Renaissance. Jeffrey Vinik, who ran Fidelity Investments' flagship Magellan Fund
                                                   before starting his own firm, returned 25% after fees in the March-April period
                                                   through judicious use of short sales and stock-picking.' Although hedge funds with
                                                   a pure short bias are rare, understanding the merits and dynamics of short selling is
                                                   important with long/short equity funds, which are the largest category of the hedge
                                                   fund universe.

  Jef f rey Vinik's name became practically sy nony mous with bad stock market calls a f ew y ears ago. As a star manager of
the largest mutual f und, Fidelity Magellan, Vinik reckoned that stocks had peaked in 1995. So he inv ested in bonds - and
balef ully watched one of the strongest stock market rallies of the decade f rom the sidelines. The results were not pretty :
Returns slumped, and inv estors withdrew money . To make matters worse, at the end of 1995 he came under SEC
scrutiny f or say ing positiv e things about stocks he was selling. He was exonerated; but when he lef t Fidelity in June 1996,
many believ e he departed with a cloud ov er his head. The hedge f und he started af ter he lef t Fidelity doubled 'inv estors'
money in 1997. The US$800m he raised when he started reached some US$4bn f our y ears later.
In Search of Alpha October 2000

                                      Short Sellers

Equity as w ell as fixed              The short selling discipline has an equity as well as fixed income component. Short
incom e elem ent                      sellers seek to profit from a decline in the value of stocks. In addition, the short
                                      seller earns interest on the cash proceeds from the short sale of stock. Tremont
                                      (1999) estimates that short sellers make up around 0.5% of all funds, representing
                                      0.4% of all assets under management.


The current bull m arket has          Given the extensive equity bull market, short selling strategies have not done
nearly driven short sellers           particularly well in the recent past. Their performance is nearly a mirror image of
into extinction                       equities in general. Chart 10 compares annualised returns of short sellers with the
                                      MSCI World index. We will focus on risk and return characteristics in more det ail
                                      in the performance analysis section on p132.
Table 18: Key Risk Factors
    Risk         Position             Effect
    Equity       Short bias           Most often short delta, otherwise long/short fund. Usually short in large capitalisation stocks since larger
                                      capitalized stocks can be borrowed to be sold short more efficiently.

                                      Given the experience of the 1990s, one of the lar gest risks is momentum where overvalued stocks continue to
                                      outperform. A further risk is that the borrowed stock is re-called.

    Credit       Short default risk   Collateral has usually little default risk. Short sellers are therefore short default risk since the strategy benefits if
                                      short equity positions default.

Interest rates   Short duration       If interest rates fall, the proceeds from the fixed income portion used as collateral as well as the rebate on the
                                      proceeds from the short sell are reduced.
Source: UBS Warburg

The short seller borrow s the         Short sellers borrow stock and sell it on the market with the intention of buying it
stock and earns interest on           back later at a lower price. By selling a stock short, the short seller creates a
the proceeds from s elling            restricted cash asset (the proceeds from the sale) and a liability since the short seller
stock short                           must return the borrowed shares at some future date. Technically, a short sale does
                                      not require an investment, but it does require collateral. The proceeds from the short
In Search of Alpha October 2000
                                          sale are held as a restricted credit by the brokerage firm that holds the account and
                                          the short seller earns interest on it - the short interest rebate.

Security selection is a key               Security selection is the key driver of returns in the segment. A theme in 1999 that
driver                                    contributed to positive security selection on the short side was the exploitation of
                                          aggressive accounting by certain companies' management. These practices typically
                                          involve the acceleration of revenue recognition or the accounting of extraordinary
                                          items like mergers and acquisitions.

Exam ple                                  Tyco International, in its recording of large reserves on acquisitions in 1999, is an
                                          example of aggressive accounting practice. By taking large reserves, Tyco avoided
                                          future depreciation/amortisation charges against profits and thereby showed
                                          increasing growth in earnings. While the company theoretically complied with
                                          GAAP, it was this methodology of aggressive accounting that had p rovided a
                                          source of short ideas.

Web of dysfunctional                     Securities and Exchange Commission Chairman Arthur Levitt broached the role of
relationships                            Wall Street analysts in regards to the issue of aggressive accounting. In a speech in
                                         October 1999, he noted a "web of dysfunctional relationships" between Wall Street
                                         and corporate America that encourages analysts to rely too heavily on company
                                         guidance for earnings estimates and pushes companies to tailor results for the
           Street's consensus estimates. He continued to argue “…analysts all too often are
                                          falling off the tightrope on the side of protecting the business relationship at the cost
                                         of fair analysis." Many hedge funds managers argue that while Wall Street research
                                         is of limited value on the long side, it is of even less value on the short side due in
                                         large part to the conflicts mentioned by Mr. Levitt. This leaves hedge fund
                                         managers in the short discipline to uncover profitable short opportunities through
                                         their own research and security selection.
In Search of Alpha October 2000

                                            Emerging Markets

Emerging market hedge                       Emerging market hedge funds focus on equity or fixed income investing in
funds are not regarded as a                 emerging markets as opposed to developed markets. This style is usually more
typical hedge fund strategy                 volatile not only because emerging markets are more volatile than developed
                                            markets, but because most emerging markets allow for only limited short selling
                                            and do not offer a viable futures contract to control risk. The lack of opportunities
                                            to control risk suggests that hedge funds in emerging markets have a strong long
                                            bias. According to Tremont (1999), emerging markets represent 5.6% of all funds
                                            and 3.5% of all assets under management.
Table 19: Key Risk Factors
Risk      Position Effect
Equity             Long bias            Usually long exposure to market risk. Stock specific risk usually div ersified. Limited
                   opportunity to sell short or use deriv ativ es.

         One of the main differences betw een emerging markets and dev eloped markets from a risk perspectiv e is that correlation among stocks
in an emerging market is much higher than in dev eloped markets w hereas the correlation among emerging markets themselv es is l ow er than
among dev eloped markets.

The country factor is the main v ariable.

Credit    Long default risk    Large exposure to the countries credit rating.

 Currency Neutral                           Macro funds are famous for currency bets. Emerging market funds buy and sell underv alued financial
                                            instruments and hedge, w hen possible, residual risk such as currency. The focus is on exploiting
                                            inefficiencies as opposed to taking currency bets.

 Liquidity Long liquidity                   Emerging market hedge funds are long inefficient markets and illiquid securities. They prov ide and
                                            enhance liquidity.

Source: UBS Warburg

Risk or opportunity?                        A risk to the pessimist is an opportunity to the optimist. Investing in emerging
                                            markets therefore is full of risks or opportunities, depending on your viewpoint. The
                                            risks include the difficulty of getting information, poor accounting, lack of proper
                                            legal systems, unsophisticated local investors, political and economic turmoil, and
                                            companies with less experienced managers. The opportunities are due to yet -to-be
                                            exploited inefficiencies or undetected, undervalued and under-researched securities.

The 1994 Mexican Peso                       The 1994 Mexican Peso Crisis, when the Mexican Peso devalued by more than
Crisis                                      40% in December 1994, is an interesting example of the difference between a
                                            traditional emerging market fund and an alternative emerging market fund.

                                            Table 20: Hedge Fund versus Mutual Fund Returns During Peso Crisis
                                                                          MSCI Latin Mutual Funds speciallsed Hedge Funds speciallsed
                                                                      American Index          in Latin America       in Latin America*
                                                                                   %                          %                          %
                                              December 1994                     -15.0                       -17.4                      -3.6
                                              January 1995                      -11.0                       -14.0                      -6.3

                                            Source: Fung and Hsieh (2000)
                                            * HFRI Emerging Markets Latin American Index
In Search of Alpha October 2000

Em erging m arket hedge                 There were 18 hedge funds managing US$1.8bn specialised in Latin America from
funds outperform ed                     the I1FR database. 1 The average returns were -3.6% and -6.3% respectively. This
em erging m arket m utual               compares with -15.0% and -11.0% respectively for the MSCI Latin American
funds                                   Index. In comparison, Lipper Inc. reported that there were 19 US equity mutual
                                        funds specialising in Latin America, with assets of US$4.3bn. These funds returned
                                        on average -17.4% in December 1994 and -14.0% in January 1995. This was more
                                        or less in line with the benchmark index.
Hedge funds hedge the                   One explanation for the speciality hedge funds outperforming the benchmark
risks they do not w ant to be           indices and mutual funds was that they had earlier hedged their Latin American
exposed to                              positions. Another explanation is that the speciality hedge funds were primarily
                                        betting on Brady bonds (which are denominated in US Dollars and therefore have
                                        no currency risk), as their returns were more in line with those of Brady bonds than
                                        Latin American equities.
                                        In our opinion, this highlights two characteristics of investing in hedge funds:

(1)       By investing in a speciality hedge fund, one is not necessarily buying the
                                                 beta of the local asset class, in this case emerging markets. The hedge fund
                                                 manager might seek investment opportunities elsewhere (Brady bonds) and
                                                 hedge unwanted risks (currency swings). This means that returns can be
                                                 uncorrelated with traditional funds;

(2)       It also means that transparency is lower. If the plan sponsor is not in
                                                 constant dialogue with the hedge fund manager, transparency is low. Even
                                                 if there is a dialogue, the hedge fund manager might not want to reveal his
                                                 positions, especially not the short positions.
In Search of Alpha October2000

                                 Long/Short Equity

                                 Long/short equity is by far the largest discipline. According to Tremont (1999), this style
                                 represents around 30.6% of all funds and 29.8% of all assets under management.

Freedom to use leverage,         Nicolas (1999) classifies this category as 'equity hedge', and he further subdivides
sell short and hedge m arket     the discipline into equity hedge and equity non-hedge. In this report we classify all
risk                             strategies with a long bias into the 'opportunistic' section and strategies which seek
                                 to eliminate market risk entirely into 'relative value'. The difference between
                                 long/short managers with long bias to traditional long-only managers is their
                                 freedom to use leverage, take short positions, and hedge long positions. Their main
                                 objective is to make money and not necessarily to beat an index. The focus of these
                                 funds can be regional, sector specific or style specific. Long/short equity funds tend
                                 to construct and hold portfolios that are significantly more concentrated than
                                 traditional fund managers.

Short sale hedges risk,          Long/short strategies combine both long as well as short equity positions. The short
enhances yield, and,             positions have three purposes, which can vary over time or by manager. First, the
potentially, generates alpha     short positions are intended to generate alpha. This is one of the main differences
                                 when compared with traditional long-only managers. Stock selection skill can result
                                 in doubling the alpha. A long/short equity manager can add value by buying
                                 winners as well as selling losers. Second, the short positions can serve the purpose
                                 of hedging market risk. Third, the manager earns interest on the short as he collects
                                 the short rebate.

Position lim its to control      Many long/short equity managers use position limits to control stock specific risk
risk and liquidity               and, more importantly, control liquidity. Some institutionalise daily P&L analysis
                                 similar to proprietary trading desks of investment banks. Selling short is not the
                                 opposite of going long.

Selling Inflated earning         The ability to sell short allows the hedge fund managers to capitalise on                 1

expectations and                 opportunities unavailable to most traditional managers. One example of a successful
aggressive accounting            short stock position done by equity long/short managers was a short position on
                                 Pediatrix Medical Group Inc., a provider of physician management services to
                                 hospital-based neonatal intensive care units.
In Search of Alpha October 2000
         In &

Example                           The company was en vogue on Wall Street in late 1998 and early 1999 due to the perceived high
                                  rate of growth in its revenues and profits. To some hedge fund managers, the stock was a
                                  potential short because the company’s projected growth rate, attributed to the industry, far
                                  exceeded the rate at which babies were being born. Further research uncovered both
                                  ‘aggressive’ accounting practices and inappropriate charges to insurance carriers. Hedge fund
                                  managers sold the stock short outright. Eventually, the company announced that earnings
                                  would be far below analysts’ expectations and officials said they were investigating the
                                  company for possible insurance fraud.

                                  This concludes our brief description of hedge fund strategies. On pp98-150 we analyse risk,
                                  return and correlation characteristics of the strategies just described. On the next page we
                                  summarise the findings of our performance analysis.

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